buy-sell agreement handbook, plan ahead for changes in the ownership of your business 2nd (2003)

When an owner is contemplating selling or giving away his interest, a good buy-sell agreement steps in to give the continuing owners some control over the transaction, often regulating w

Have a legal question? Chances ar

and online

For three decades, Nolo's mission has been to help people solv

e their legal

problems with confidence

, a minimum of fuss and expense

, and—whenever

possible—without a lawyer.

Over the years, we’ve offered e

very tool available to help y

ou get the job done.

In the 70s, we began publishing practical,

plain-English books containing all the

forms and step-by-step instructions necessar

y to tackle day-to-day legal tasks.

In the 80s, when personal computers took the w

orld by storm, we got to w

ork

and developed programs such as

WillMaker and Living Trust Mak

er, which took

advantage of the speed and con

venience of all those bits and b

yone with a computer and a modem

Most recently, we opened our online Do

wnload Center, where you can find

all of Nolo's convenient, topical ePr

oducts The fastest, easiest wa

y to do your

own legal work, eProducts deliv

er specific forms and information dir

ectly to

your computer.

Does this mean we plan to abandon our books in print?

Absolutely not As

technology evolves and the Internet expands,

we will continue to redesign

and improve all our current products,

making your access to the la

w the best

it can be

AT THE NOLO.COM SELF-HELP LAW CENTER, YOU’LL FIND

• Nolo’s comprehensive Legal Encyclopedia filled with plain-English

information on a variety of legal topics

• Nolo’s Law Dictionary—legal terms without the legalese

• Auntie Nolo—if you’ve got questions, Auntie’s got answers

• The Law Store—over 200 self-help legal products including

Downloadable Software, Books, Form Kits and eGuides

• Legal and product updates

• Frequently Asked Questions

• NoloBriefs, our free monthly email newsletter

• Legal Research Center, for access to state and federal statutes

• Our ever-popular lawyer jokes

Law Books & Software for Everyone

Nolo’s user-friendly products are consistently first-rate Here’s why:

• A dozen in-house legal editors, working with highly skilled authors,

ensure that our products are accurate, up-to-date and easy to use

• We continually update every book and software program

to keep up with changes in the law

• Our commitment to a more democratic legal system informs all of our work

• We appreciate & listen to your feedback Please fill out and

return the card at the back of this book

Our

“No-Hassle” Guarantee

Return anything you buydirectly from Nolo for anyreason and we’ll cheerfully re-fund your purchase price

No ifs, ands or buts

The information in this book is as up to date and accurate as we can make it But it’simportant to realize that the law changes frequently, as do fees, forms and procedures.

If you handle your own legal matters, it’s up to you to be sure that all information you use—including the information in this book—is accurate Here are some suggestions to help you:

First, make sure you’ve got the most recent edition of this book To learn whether a lateredition is available, check the edition number on the book’s spine and then go to Nolo’s onlineLaw Store at www.nolo.com or call Nolo’s Customer Service Department at 800-728-3555

Next, even if you have a current edition, you need to be sure it’s fully up to date The lawcan change overnight At www.nolo.com, we post notices of major legal and practical changesthat affect the latest edition of a book To check for updates, find your book in the Law Store

on Nolo’s website (you can use the “A to Z Product List” and click the book’s title) If you see an

“Updates” link on the left side of the page, click it If you don’t see a link, that means wehaven’t posted any updates (But check back regularly.)

Finally, we believe accurate and current legal information should help you solve many ofyour own legal problems on a cost-efficient basis But this text is not a substitute for personal-ized advice from a knowledgeable lawyer If you want the help of a trained professional, consult

an attorney licensed to practice in your state

by Attorneys Anthony Mancuso & Bethany K Laurence

Buy-Sell

Agreement Handbook

Plan Ahead for Changes in the Ownership of Your Business

Book Design TERRI HEARSH

Mancuso, Anthony.

Buy-sell agreement handbook: plan ahead for changes in the ownership of your business

/ by Anthony Mancuso & Bethany K Laurence. 2nd ed.

1 Sale of business enterprises Law and legislation United States Popular works I.

Laurence, Bethany K., 1968- II Mancuso, anthony How to creat a buy-sell agreement

& control the destiny of your small business III Title.

KF1659.Z9M36 2003

346.73'0652 dc21

2003048773

Copyright © 1999 and 2003 by Anthony Mancuso and Nolo ALL RIGHTS RESERVED PRINTED IN THE USA.

No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher and the author.

Reproduction prohibitions do not apply to the forms contained in this product when reproduced for personal use.

For information on bulk purchases or corporate premium sales, please contact the Special Sales Department For academic sales or textbook adoptions, ask for Academic Sales Call 800-955-4775 or write to Nolo, 950 Parker Street, Berkeley, CA 94710.

whose encouragement and guidance helped make this book a reality Major thanks to TerriHearsh for her patience and hard work in designing and laying out the book and to ToniIhara for her colorful cover Also, sincere thanks go to Mike Mansel for reviewing thefunding and insurance chapter and to Walter Gibbons for lending a keen eye to the taxlaw chapter.

Dedication

To Jason, who became my husband somewhere in between the second and third drafts,without whose warm support and tireless tolerance I might not have finished this book,and to my mother and father, who continually encourage me to achieve whatever mark Iset my sights upon

—BKL

series, including How to Form Your Own California Corporation and Incorporate Your Business Tony’s recent books include The Corporate Minutes Book and Your Limited

Liability Company: An Operating Manual Tony is a jazz guitarist and a licensed helicopter

1 An Overview of Buy-Sell Agreements

A What Is a Buy-Sell Agreement? 1/3

B Why Should You Create a Buy-Sell Agreement? 1/4

C When Should You Create a Buy-Sell Agreement? 1/8

D How to Use This Book 1/9

2 Limiting the Transfer of Ownership Interests

A Transferring Ownership Interests 2/2

B Right of First Refusal 2/2

C Absolute Transfer Restrictions 2/11

3 Providing the Right to Force Buyouts

A Why Provide the Right to Force the Sale of an Ownership Interest? 3/3

B What If an Owner Wants to Retire or Stop Working? 3/5

C What If an Owner Becomes Mentally or Physically Disabled? 3/13

D What If an Owner Dies? 3/18

E What If an Owner Divorces? 3/26

F What If an Owner Loses His or Her Professional License? 3/29

G What If an Owner Files for Personal Bankruptcy? 3/31

H What If an Owner Defaults on a Personal Loan? 3/33

I What If an Owner Is Expelled? 3/35

B How Our “Wait and See” Approach Works 4/5

5 Funding Buyouts

A Cash 5/2

B Borrowing 5/2

C Insurance 5/3

6 How to Set the Buyback Price in Your Agreement

A Why Choose a Price in Advance? 6/2

B What Valuation Methods Are Based On 6/3

C How Our Valuation Provisions Work 6/5

D Agreeing on a Fixed Buyout Price (Valuation Method 1) 6/6

E Buyout Formulas 6/9

7 Choosing Payment Terms for Buyouts

A Balancing the Interests of Buyer and Seller 7/2

B Lump-Sum Cash Payments 7/3

C Equal Payments Under an Installment Plan 7/4

D Combined Cash and Installment Payments 7/4

E Interest-Only Installment Payments 7/6

F Customized Schedules of Payments 7/7

8 Completing and UpdatingYour Buy-Sell Agreement

A Finalizing Your Buy-Sell Agreement 8/2

B Resolving Buyout Disputes 8/6

C Binding All Future Owners Under Your Buy-Sell Agreement 8/12

D Updating Your Buy-Sell Agreement in the Future 8/13

E Placing a Legend on Your Ownership Certificates 8/14

B Buy-Sell Estate Tax Issues 9/11

10 Lawyers, Tax Specialists and Resources

A How to Find the Right Lawyer 10/2

B Finding the Right Tax Advisor 10/4

C Resources 10/5

Appendixes

A How to Use the CD-ROM

A Installing the Form Files Onto Your Computer A/2

B Using the Word Processing Files to Create Documents A/2

C Files Included on the Forms CD A/4

B Buy-Sell Worksheet

C Buy-Sell Agreement

A What Is a Buy-Sell Agreement? 1/3

B Why Should You Create a Buy-Sell Agreement? 1/4

1 A Buy-Sell Agreement Can Control Who Can Own

an Interest in the Company 1/4

2 A Buy-Sell Agreement Can Provide a Guaranteed Buyer

for Your Ownership Interest 1/6

3 A Buy-Sell Agreement Can Set a Fair Price and a

Method for Paying For and Funding a Buyout 1/7

C When Should You Create a Buy-Sell Agreement? 1/8

1 Start Small 1/8

2 A More Sophisticated Agreement 1/9

D How to Use This Book 1/9

An Overview of Buy-Sell Agreements

1

The first days and months of a new business

are heady times As an owner, you have

more than enough things to juggle—

organizational papers, contracts and tax forms, to

mention a few—never mind the actual work to be

done The last thing you have time for is worrying

about what will happen when you or another

owner retires, divorces, dies or just decides to

move on Unfortunately, it’s a huge mistake to

ignore the fact that sooner or later your business

will lose owners and perhaps gain new ones And

when ownership interests change hands, conflicts

often arise that can upset the functioning of a

small, closely managed company If you doubt

this even for a minute, quickly skim the following

questions:

• What if your longtime friend and business

partner gets Alzheimer’s disease and his

caretaker demands to cash out his

owner-ship interest right away?

• What if your business partner gets divorced

and her husband ends up with an

owner-ship interest as part of the divorce

settle-ment? What if he tries to interfere with

man-agement to get even with his wife?

• What happens if the majority owner of your

company wants to sell her share to a

stranger, or someone you know well and

can’t stand?

• What happens if one of your co-owners

becomes alcohol or drug dependent, with

the result that her conduct is risking the

reputation of the company? Can you kick

her out?

• What happens if an older co-owner wants

to give half of his interest to his notoriously

irresponsible son, who has never worked

for the company, and elect him to the board?

The answer to all these dilemmas is the same

If you haven’t made a sound agreement to

anticipate and deal with these issues before they

happen, you’re taking a risk that friction will arise

between owners who will remain at the company

and a new owner or a departing owner Most of

the time, this tension occurs because the

continu-ing owners do not want to be forced to workwith and share control of the company with anunqualified, inactive or unlikeable owner (Afterall, most small business owners own their ownbusiness because they want to run things theirway, or at least share management with co-own-ers with whom they can comfortably and easilydeal.) When such owner-to-owner tension arises,

it can lead to serious personal and business cord, which might even be fought out in court orresult in the demise of your company

dis-To avoid these conflicts, you and your owners should arrange matters so you’ll be able

co-to collectively control who will own and managethe company in the future In other words, ifsomeone wants to buy into the company, youand the other owners can have a say If an ownerwants to give his share to his kids, you and theother owners may want to have a say If anowner wants to retire but hold on to his interest,you and the other owners may want to rearrangethings That’s why it’s best to set some groundrules ahead of time Enter the buy-sell agreement.Much like a premarital agreement, the buy-sellagreement gives owners a way to deal with own-ership disruptions in a way that won’t wreck theirbusiness, by providing pre-established rules fortransferring interests

Attention inactive, unequal or related owners

This book is geared toward companies withtwo or more owners who are unrelated, who ownroughly equal shares of the business and whoactively participate in the day-to-day management

or operations of the business If you are an owner

of a family business, where your children or thechildren of relatives will likely some day takeover the company; an owner who owns a smallminority or a large majority of a business; or asilent investor in a company, you may have someextra concerns that we don’t fully address in thisbook If this describes you, be sure to have anattorney look over your buy-sell agreement be-fore you sign it We cover finding expert help inChapter 10

A What Is a Buy-Sell Agreement?

Contrary to popular belief, a buy-sell agreement is

not really about buying and selling companies A

buy-sell agreement is a binding contract—between

you and your co-owners—that controls when an

owner can sell his interest, who can buy an

owner’s interest and what price will be paid for

that interest

Your buy-sell agreement can provide some

general guidelines to be used when the

owner-ship and control of your company is on the brink

of change At a time when many people demand

that their work be both profitable and personally

meaningful, the most common change might be

simply that a co-owner wants to sell out because

he feels like doing something else When an

owner is contemplating selling or giving away his

interest, a good buy-sell agreement steps in to

give the continuing owners some control over the

transaction, often regulating who can buy the

departing owner’s interest and at what price, or,

sometimes, whether the owner can sell his

inter-est at all (We discuss these options in Chapter 2,

“Limiting the Transfer of Ownership Interests.”)

Usually a buy-sell agreement also gives the

company and its owners an opportunity to buy

out an owner who has stopped working for the

company or has died By so doing, it eliminates

the possibility that active owners will be forced to

share profits with an inactive owner or an

unsuit-able new owner A typical buy-sell agreement

gives the company and the owners the right to

buy out an owner (that is, force an unwilling

owner to sell) when:

• an owner decides to retire from active

participation in the company, or becomes

disabled and is no longer able to actively

participate in the company

• an owner dies

• an owner’s ex-spouse stands to receive an

ownership interest in the company as part

of a divorce settlement, or

• an owner’s interest is in danger of being

confiscated by creditors (because of a

personal bankruptcy or foreclosure of adebt)

We discuss these possibilities in Chapter 3, viding the Right to Force Buyouts.”

“Pro-In addition, some buy-sell agreements give anowner the right to force the company or her co-owners to buy her interest from her under certaincircumstances A buy-sell agreement typicallygives owners this right when:

• an owner decides to retire after a certainperiod of time, or becomes disabled and is

no longer able to actively participate in thecompany, or

• an owner dies, and his estate representative

or inheritors want to sell his interest back tothe company or the continuing owners

We discuss these options also in Chapter 3

It is your job (along with your co-owners) todecide which of these provisions you want toinclude in your buy-sell agreement After readingthis book, which shows you the various buy-selloptions and how they can be useful, you andyour co-owners will select the buy-sell provisionsyou think are suitable for your company and yoursituation These provisions will later remind youand your co-owners during an ownership transi-tion how you agreed to handle a potential sale orbuyback situation

You’ll select provisions for your agreement pending on several factors, including whether youwant to keep your company very small and pri-vate, how long you expect your business to lastand who you expect to succeed you when youdie

de-After you select the appropriate buy-sell tions and sign your buy-sell agreement, it willthen probably sit quietly in a dusty file until you

op-or a co-owner wants to part with his ownershipinterest or until an event happens that causes thecompany or co-owners to want to buy out anowner When one of these circumstances occurs,the buy-sell agreement will kick in to protect yourcurrent way of doing business

Family Businesses

Buy-sell agreements are just as crucial for

family-owned businesses as they are for companies

owned by unrelated business associates

Although some family members may not want

to consider the chance that there may be

disagreements in the future, the truth is that

serious disputes can and often do arise in

family businesses just as they do in families

themselves In fact, when it comes time to deal

with issues of inheritance, succession and

estate taxes, family businesses often have an

even more pressing need for a buy-sell

agree-ment We briefly discuss issues that apply to

passing the family business from one generation

to the next in Chapter 3, Section D

B Why Should You Create

a Buy-Sell Agreement?

We have mentioned several reasons why it is a

good idea for most small business owners to

agree in advance on buy-sell provisions Because

it is so important, it makes sense to look at the

purposes of a buy-sell agreement in more detail

Put bluntly, if you do not have a buy-sell

agree-ment, here is what may happen:

• You may be forced to work with and share

control of the company with an

inexperi-enced or untrustworthy stranger who buys

the interest of a departing co-owner

• You may be forced to work with the spouse

or other family member of a deceased or

divorced owner While this might be fine,

there is always the substantial possibility

that the family member might be

inexperi-enced, bitter or immature

• You may be stuck co-owning the company

with a bankruptcy trustee or creditor if a

co-owner is forced to file for personal

bank-ruptcy or defaults on a personal loansecured by his ownership interest This cancreate business delays and prevent you fromgetting bank loans

• If you leave the company or die, you oryour survivors may be stuck with a smallbusiness interest that no outsider wants tobuy and for which no insider will give you adecent price

• You and your co-owners may argue with adeparting co-owner or her inheritors overwhat price should be paid for the interestthat is changing hands, resulting in an angrydeadlock that spills over into businessoperations

Let’s look at how a buy-sell agreement canavoid these situations

1 A Buy-Sell Agreement Can Control Who Can Own an Interest in the Company

An outsider who gains an ownership interest candisrupt business as usual and trigger majorproblems in any small company’s management.For example, a disagreeable new owner, orsimply one with different goals, may not see eye

to eye with the existing owners on the election ofthe management team (board of directors, generalpartners or limited liability company managers),the amendment of organizational documents orthe approval of important management decisions.And since unanimous agreement of all owners isrequired for certain decisions, a new owner couldhold up important company actions

Even worse, an unwanted outsider in a ration, especially one who buys or inherits a largeblock of shares, can gain control by electing her-self to the board of directors (see “How an Out-sider Can Take Control of a Small Corporation,”below) In an unincorporated business, an out-sider can sometimes take control automatically bybecoming a majority owner in the partnership orlimited liability company (LLC)

corpo-An outsider who purchases an ownership interest in

a small corporation can sometimes gain control by

electing himself to the board of directors Since

shareholders cast one vote per share under normal

shareholder voting rules, if a shareholder owns a

substantial number of shares, the votes she casts for

herself as a nominee to the board can be sufficient

to ensure her election (since the nominees receiving

the greatest number of votes are elected as board

members) And once a person becomes a board

member, she becomes an equal participant on the

board; unlike a shareholder, whose voting power is

proportionate to shareholdings, each board member

exercises one vote

Let’s look at how an unwelcome outsider can

disrupt a company’s management

EXAMPLE: Cousins Xavier and Yolanda

incorpo-rate a small business, with Xavier receiving 55%

of the corporation’s shares and Yolanda 45%

Each cousin serves as a director of the

corpora-tion Young, healthy and actively involved in

the business, the cousins don’t give any thought

to creating a buy-sell agreement to cope with

what happens if one of them wants to move on

A few years later, after the success of their

business had surpassed initial expectations,

Xavier and Yolanda have a falling out over

whether to significantly expand the business To

escape from the resulting tension, Xavier sells

his 55% interest to Richard, a wealthy investor

Yolanda doesn’t even know, and sets off to

spend his days sailing the sunlit Caribbean

Richard immediately elects himself to the

board of directors (This is possible because he

voted 55% of the total number of corporate

shares for himself—enough to outweigh Yolanda’s

vote for a different nominee to the board.) Being a

director entitles Richard to participate equally

with Yolanda in management decisions He

immediately proposes laying off several loyal

employees in order to maximize short-term

profits, with an eye towards making a quick and

How an Outsider Can Take Control of a Small Corporation

lucrative sale of the company This horrifiesYolanda, who is interested in the long-termhealth and growth of the business Richard andYolanda quickly reach an impasse in corporatedecisionmaking and Yolanda files a minority-shareholder lawsuit, trying to unseat Richard.This escalates their personal and professionalconflicts, with the result that the company’s day-to-day operations practically come to a stand-still

Now we look at how a buy-sell agreement mightwork to protect the legitimate interests of smallbusiness owners

EXAMPLE: Let’s reroll our cameras and giveXavier and Yolanda another chance CousinsXavier and Yolanda incorporate a smallbusiness, again with Xavier receiving 55% andYolanda 45% of the corporation’s shares Eventhough they are young, healthy and activelyinvolved in the business, they realize they don’tknow what will happen five years down theroad The cousins create a buy-sell agreement tocope with what happens if one of them wants tomove on A few years later, Xavier and Yolandahave a falling out over whether to significantlyexpand the business Realizing he can no longerwork efficiently with his cousin since they nowhave different goals, Xavier decides to sell hisshares and move on Xavier lets the word outthat his shares are for sale, and Richard, anoutside investor, offers him $10 per share for hisinterest Xavier shows the written offer toYolanda Yolanda is wary of Richard, since shedoesn’t even know him, and decides she doesn’twant to share control of the company with him

So she offers to buy the shares from Xavier self, for $10 per share Xavier, required by thebuy-sell agreement to do so, sells her the shares.Yolanda continues business as usual, managing

her-it as the sole shareholder and director, treats heremployees well and lives happily ever after

To prevent unhappy ownership transitions, a

well-drafted buy-sell agreement gives owners the

power to prevent outsiders from buying in, or to

purchase an owner’s interest after he dies rather

than allow his inheritors to become owners We

look at the ways a buy-sell agreement can grant

these rights in Chapters 2 and 3

Who Does Not Need

a Buy-Sell Agreement?

Almost every business with more than one

owner should have a buy-sell agreement In a

few situations, however, a buy-sell agreement

may not be necessary If you are a sole

propri-etor—you own 100% of a company—you

prob-ably do not need a buy-sell agreement, unless

you plan on selling the business to an

em-ployee who is willing and able to take over (see

“Life Insurance Funding for Sole Proprietorships,”

in Chapter 5, Section C2) Or, if you and your

long-time, highly compatible spouse (with

whom divorce is highly unlikely) own 100% of

a company, there normally is little reason to

bother creating a buy-sell agreement It’s

un-likely that either of you will want to get out of

the company unless you both do, and if one of

you dies while you still own the business, the

other person will probably inherit the

owner-ship interest Likewise, if you own a small

busi-ness with a child to whom you plan to leave

your share of the business at your death, it may

be sensible to forgo a buy-sell agreement and

just put your wishes in a will or trust (Unless

your estate may owe estate taxes—see Chapter

9, Section B.) But even here there is always the

possibility that your child will die, divorce or

want to leave the business before you do, so an

agreement still makes sense In short, there may

be some situations where it is highly unlikely

you’ll need the protection of a buy-sell

agree-ment, but you usually take some sort of risk by

not having one

2 A Buy-Sell Agreement Can Provide a Guaranteed Buyer for Your Ownership Interest

Besides protecting your company as a whole, abuy-sell agreement can help you individually, ifthe time comes when you want or need to sellyour ownership interest Having a buy-sell agree-ment that provides for forced buyouts can end upprotecting you and your family from financialhardship and hard feelings

It shouldn’t come as a surprise that it can bequite difficult to sell a less-than-100% share of asmall business Often it is in fact impossible tofind an interested buyer, especially if you’re trying

to sell a minority interest Why is this so? ber that a minority share gives an owner little or

Remem-no control over how the business is run Think of

it this way: If your dream has been to own andrun your own business, would you be likely tosettle for a tiny piece of someone else’s? Probablynot—if you are like most people

As a result, if at some point you want to leavethe business but your co-owners won’t pay a fairprice for your interest, you may be stuck with ashare of the company that you can’t sell, instead

of having cash to spend or invest elsewhere.Same goes for your heirs, if they inherit yourchunk of the company after you die

EXAMPLE: Albin, Bertram and Carmen, workers in a large cosmetics company, quittheir jobs to form a natural cosmetics corpora-tion Unfortunately, although they spend a lot

co-of time developing a business plan andorganizing their business, they adopt no buy-sell agreement or mechanism to fund a buyoutshould one of them want to sell out

Three years after the corporation was formedand just when it is beginning to earn substantialprofits, Bertram dies, soon after his fiftiethbirthday His wife and two children eachinherit an equal number of his shares But hiswife soon becomes strapped for cash, and hiskids, still in college, also need money Neither

his wife nor the kids are interested in

continu-ing the business Albin and Carmen, knowcontinu-ing

Bertram’s heirs probably can’t find an outside

buyer, plead poverty and initially refuse to buy

the shares Bertram’s wife and kids are stuck,

until they eventually sell their shares to Albin

and Carmen, who finally agree to buy them for

far less than they were really worth

This is not an uncommon situation in small

businesses Often, when an owner dies, the last

thing family members want to worry about is

picking up the business where the owner left off

But families who are grieving the loss of a loved

one may also suffer financially, from living

ex-penses, funeral costs and death taxes In that case,

it’s helpful for an inheritor who does not want to

carry on the business to be able to offer her

inter-est to the company and the remaining owners of

the company and be guaranteed that they’ll buy it

for a fair price

In your buy-sell agreement, you can require

that your company or your co-owners buy your

ownership share not only after your death, but

also in other circumstances as well For instance,

if you have to move out of state for family

rea-sons and want to sell your ownership interest, or

you become disabled and can no longer work,

your agreement could require your company or

co-owners to buy your share from you In effect,

this type of provision “makes a market” for your

interest where one might not naturally exist If

you and your co-owners don’t create a buy-sell

agreement, there’s no guarantee you or any other

owner could find an investor willing to pay you a

fair price for your share We look at these

situa-tions more thoroughly in Chapter 3

3 A Buy-Sell Agreement Can Set a

Price and a Method for Paying For

and Funding a Buyout

An important part of adopting a well-thought-out

buy-sell agreement is setting a price at which

ownership interests will be transferred Withoutestablishing a price for the company in advance—

or at least a formula for setting the price—lengthydisputes and lawsuits can arise over the value of

an ownership interest Not only are these ments almost sure to result in personal ill will,they may even disrupt the ongoing business tothe point that the company loses its edge and is

disagree-in danger of faildisagree-ing

However, it can be difficult to value a small orfamily-owned business Sure, you can add up thevalue of property, equipment and accounts re-ceivable, but what about the value of your cus-tomer lists and your business’s reputation? Shouldthese get factored into the equation? And, ofcourse, whatever number you come up with, adeparting business partner is likely to have a dif-ferent idea of the company’s worth: perhaps aprice based on the high profit she expects thecompany to bring in next year

Likewise, a company that doesn’t plan how it

will pay a departing owner (or his familymembers) can be in for trouble Having to come

up with a large lump-sum payment out of theblue can cause a company to drown in financialhot waters These issues can be extremelyproblematic if they are not determined until thetime when the ownership interest has to bebought back

Fortunately, in addition to providing a way tovalue an ownership interest, a good buy-sellagreement can set forth the mechanics of a buy-out—including the specific payment terms andthe source of the funding For instance, if anowner wants the company to buy back his interestand pay for it on the spot, the company mayneed to borrow the cash (of course, some can’t)

or liquidate assets to make the payment That’swhy it’s often better to provide in advance that adeparting owner (or his family members) can bepaid in installments over a period of years An-other alternative is to require the purchase of life

or disability insurance for each of the businessowners—and then use the proceeds to buy anowner out Without a funding mechanism and a

reasonable payment plan, in some cases your

company’s only other option might be to file for

bankruptcy—something you surely want to avoid

EXAMPLE: Imagine the same circumstances as

the above example, except this time Albin,

Bertram and Carmen create a buy-sell

agree-ment at the outset The agreeagree-ment protects the

owners’ inheritors by requiring the corporation

to buy back an inheritor’s interest at the

Agree-ment Price—in this case, a price based on the

company’s book value It also provides that

the buyout will be funded with

company-pur-chased life insurance The life insurance

pro-ceeds will keep the remaining owners from

having to take out loans or sell assets Thanks

to the buy-sell agreement, Bertram’s wife and

kids receive a reasonable sum for their shares,

at no financial strain to the company

We discuss funding buyouts in Chapter 5,

setting a buy-sell Agreement Price in Chapter 6

and structuring payment terms in Chapter 7

C When Should You Create

a Buy-Sell Agreement?

Procrastination is a vice most of us share, and that

includes many small business owners, no matter

how shrewd they may be Unfortunately, in the

area of business planning, it can lead to financial

undoing Many owners of successful businesses

put off creating a buy-sell agreement—because

they don’t have time, or they think everything’s

peachy—until it’s too late In short, no matter

what stage you’re at in the business game, the

time to create a buy-sell agreement is now

When you’re forming a new business, by the

time you have the notion that you need to talk

about “What happens if …,” fatigue has probably

set in Oftentimes little energy is left over for

hashing out the provisions of a buy-sell

agree-ment But the key to a buy-sell agreement is that

all owners agree to a reasonable plan early on,

before anyone knows who will be most affected

by it Think of it this way: At the outset, eachowner’s concerns are roughly the same, because

no owner knows who will be the first to leave Orput another way, it’s only when no one wants tosell out that everyone has the same interest increating an evenhanded buy-out agreement that’sfair to all owners

Not coincidentally, the best time to discussthese issues is during the formation stage of yourcompany, when you’re already discussing otherpotentially touchy issues—such as the amounteach owner will invest, the salaries or draws eachowner-employee will take home and the policiesthat will guide your company

New owners sometimes worry that focusing onproblems surrounding an owner’s leaving casts ashadow over their new business Just the opposite

is true: Facing the fact that problems can ariseand that negative things do happen can behealthy for your business relationship Airing con-cerns, and perhaps a little dirty laundry, oftenhelps you to head potential problems off or, ifthat’s impossible, to be sure they will be handledsmoothly, without putting your business’s survival

at risk Knowing that possible changes are ered and planned for can act as a reality checkand a stabilizing force and can increase your trust

cov-in what the future will be like

1 Start Small

Hopefully you’ve decided not to put off untiltomorrow what you can do today, and will diveinto creating a buy-sell agreement with us If yourbusiness is brand new and will start small, youand your co-owners probably want to create avery simple buy-sell agreement at the outset.Your agreement should concentrate on givingyour company and/or continuing owners the right

to buy a selling or departing owner’s share at afixed price, or a price to be set according to asimple formula, such as book or appraised value(discussed in Chapter 2)

There’s no need to spend a lot of time on

com-plex valuation formulas (for example, the

capitali-zation-of-earnings method) at this point In fact,

you couldn’t use one of the more complicated

formulas early on even if you wanted to—they

require that you be in business for a few years

Later, as the worth of your company grows, and

as you develop an earnings history, you can

refine your valuation formula to reflect changes in

the company’s assets and earnings

Older owners may want to mesh their

buy-sell agreement with estate planning

needs If you and your co-owners are forming a

new company, are contributing a lot of cash or

property and are in your fifties or sixties, you may

want to consult an estate planner before you adopt

your agreement In particular, choosing the right

valuation formula early on can have a minimizing

effect on estate taxes when you or a co-owner

dies We discuss estate taxes as they relate to

buy-sell agreements in Chapter 9, Section B

2 A More Sophisticated Agreement

If you’ve been in business at least two or three

years, you might want to make a more complex

agreement now Same goes anytime one of the

following is or becomes true:

• your company’s assets are quite valuable, or

• limiting the impact of estate taxes is an issue

for older owners (see Chapter 9, Section B)

If one of these statements reflects your situation,

plan on making a more developed buy-sell

agreement, complete with a detailed valuation

method (that includes the worth of your

company’s goodwill) and a sophisticated way to

fund a buyout that takes tax strategies into

account We cover these issues in the chapters to

come

D How to Use This Book

Throughout the text, we present and explainvarious buy-sell provisions you can use to handleownership transition issues, from deciding whichpotential problems may affect you and yourcompany to choosing how you’d prefer to handlethese dilemmas

We provide a lot of the legal and tax tion you need to make informed choices aboutthe future of your company, including the follow-ing major issues that will help you decide on theterms of your buy-sell agreement:

informa-• how to put limits on whom an owner cantransfer his interest to (Chapter 2)

• how to provide for forced buyouts in certaincircumstances (Chapter 3)

• how to set the procedure for future buyouts(Chapter 4)

• how to fund future buyouts (Chapter 5)

• how to set the price that will be paid forownership interests (Chapter 6)

• how to set the terms of payment (such as aninstallment plan) (Chapter 7)

• how buy-sell agreements can affect ordinaryincome and capital gains taxes and estatetaxes (Chapter 9)

Throughout the book, after introducing you tothese concepts, we help you choose the provi-sions that are right for your company To keeptrack of the options that interest you, and any re-lated thoughts you may have, we provide youwith a worksheet that follows the order of thechapters and the issues we discuss

Before you start reading Chapter 2, tear out theworksheet from Appendix B, and keep it by yourside while you’re reading The text will promptyou to check various options and jot down anyrelevant notes on your worksheet Finally, whenyou’ve gone through the book, you simply fill inthe blanks in the buy-sell agreement we provide(as a tear-out form in Appendix C and as a wordprocessing document on the CD-ROM), referring

to the worksheet to refresh your memory

Icons Used in This Book

Throughout this book, these icons alert you to

certain information

Fast Track We use this icon to let you

know when you may skip information

that may not be relevant to your situation

Warning This icon alerts you to potential

problems

Recommended Reading When you see

this icon, a list of additional resources

that can assist you follows

Tip A legal or common sense tip to help

you understand or comply with legal

requirements

See an Expert Lets you know when you

need the advice of an attorney,

accoun-tant or other expert

Cross Reference This icon refers you to

a further discussion of the topic

else-where in the book

Worksheet When you see this icon, the

text will tell you to make a notation or

check an option on your worksheet, as explained

above

One practical suggestion: Take it easy As you

read through the book for the first time, you may

feel a bit discombobulated by the numerous

possibilities that can be covered in a buy-sell

agreement Expect to feel a bit overwhelmed Not

every company needs to cover every contingency

And there’s no need to grasp every detail the first

time through Start by reading the entire book to

get a rough understanding of what’s involved and

making a few observations on your worksheet

about what situations or provisions might beparticularly applicable to you

Then spend time considering what you want tohappen to your business when you are no longer

in charge; creating a buy-sell agreement has portant, long-term consequences for you and yourfamily, and your finances Allow plenty of timefor discussions with your co-owners—talk, argueand speculate Perhaps give each owner aworksheet of their own to fill out When you’reready, go back, focus on the areas of most con-cern and begin to pin down exactly what youwant in your agreement

im-When you’ve all agreed on your decisions,you’ll simply transfer your choices from yourworksheet to the blank buy-sell agreement weprovide You’ll end up with an agreement thatcan handle all the predicaments that we discussedabove, as well as a few more

Check your agreement with an expert.

While we provide a lot of information, wecannot provide the depth of advice, especially inthe tax and estate planning realms, that a buy-sell

or financial planner or a tax expert can provide.And of course, since we don’t know you andyour particular business, we can’t customize anagreement for you that exactly suits yourcompany’s and each owner’s individual needs,though we do make every attempt to providedifferent alternatives and tips on customizing yourown agreement

So, in general, we recommend you bring your

draft buy-sell agreement to a small business tax or

legal advisor before putting your finalized

agree-ment into action Consultations of this sort are

invaluable to make sure that you have considered

all the relevant tax angles and the contingencies

that apply to your particular business If the needs

or circumstances of the owners are substantially

different, each owner may wish to check out the

tax and estate planning repercussions with his or

her individual tax advisor or financial planner

Although you must pay professional fees for

document review and any additional individual

consultations with your tax specialist, you’ll still

save thousands by not asking a small business

lawyer or tax advisor to create your buy-sell

agreement from scratch In Chapter 10, we

discuss how to find a legal “coach”—a helpful

professional who will review your papers and

double-check your self-help legal efforts

In addition, a lawyer can make sure that your

new buy-sell provisions don’t conflict with

exist-ing provisions of your business’s organizational

documents—your articles or bylaws or

partner-ship agreement or LLC operating agreement See

Chapter 8, Section A for more information

If you decide to have an expert prepare your

buy-sell agreement rather than do it yourself,

you’ll benefit greatly by knowing the critical

is-sues and what your options are You may want to

create a draft of a buy-sell agreement—or at least

fill out the worksheet—and bring it with you toyour first meeting, along with any questions youhave It will help your planner immensely inknowing where you’re at and what you want out

of an agreement, saving you time and money

Of course, planning in advance to contendwith likely disputes is not the same thing as say-ing you can prevent change For good or bad,your ownership situation is almost sure to be dif-ferent five years hence The point is that crafting

a good buy-sell agreement can make this process

as positive as possible, and will help you avoidchange’s most unfavorable aspects So, as youread about all the horrible things that can happen

to a company and its owners, don’t let the specter

of changes of ownership and resulting conflictsget you down

Remember why you started your own business.Doing your own thing allows you to work withpeople you enjoy and to control your owndestiny A buy-sell agreement will make sure itstays that way Getting along with your co-ownersand making decisions together from the start canmake a world of difference in the future of yourcompany Begin by being frank with your co-owners and family members now We areconfident that reading this book closely with yourco-owners will leave you with a comprehensivebuy-sell agreement that will protect you and yourco-owners for years to come ■

A Transferring Ownership Interests 2/2

B Right of First Refusal 2/2

1 What If an Owner Wants to Sell Her Interest to an Outside Buyer? 2/2

2 What If an Owner Wants to Sell His Interest to a Current Owner? 2/7

3 What If an Owner Wants to Give Away Her Interest (or Put It in a Trust)? 2/8

C Absolute Transfer Restrictions 2/11

Limiting the Transfer of Ownership Interests

2

In an age when many people change jobs or

even careers a number of times during their

adult life and when businesses are opened

and closed with head-spinning speed, it’s a bit of

a risky bet that you and your co-owners will all

be doing the same thing even five years from

now At some point during the life of your

busi-ness, you or one of your business’s co-owners

will probably want to sell your interest in the

business and move on to do something else For

that reason, the most common event that can

dis-rupt a small business involves an owner’s wanting

to sell or transfer her interest in the company

A Transferring

Ownership Interests

One way an owner might try to transfer her

inter-est is to sell it to an outside buyer (anyone not a

current owner)—assuming she’s lucky enough to

find one Another, probably more likely, sales

scenario is for one or more of her co-owners to

purchase her share (or for the company itself to

buy the interest back) Or, an older owner may

want to transfer all or part of her ownership

interest to a trust, or give it to her children as part

of her estate planning

To help you and your co-owners maintain

control of your company, it’s essential to create in

advance an impartial method for reviewing

poten-tial ownership transfers and blocking any

undesir-able ones The best way to do this is to adopt a

buy-sell provision that gives the company or

co-owners the right to buy an owner’s interest beforeit’s sold, given away or otherwise transferred(called a “Right of First Refusal”) This provisioncovers all the scenarios discussed above; essen-tially, it covers any attempt by an owner to transfer

an ownership interest in the company—by sale,gift or otherwise

B Right of First Refusal

To avoid the scary possibility that an unwantedperson might buy (or otherwise be transferred) aninterest in your business, most buy-sell agreementssensibly contain a “Right of First Refusal”

provision requiring an owner to first offer hisinterest for sale to his company and co-ownersbefore selling it or transferring it to anyone else.Depending on the needs of your company, youmay want this type of restriction to apply onlywhen an owner considers transferring his interest

to an outsider But there can also be reasons whyyou might want this type of restriction to applywhen an owner is considering transferring hisinterest to an insider—a current owner

1 What If an Owner Wants to Sell Her Interest to an Outside Buyer?

Should a co-owner have the unconditional right totransfer his interest in the business to someone who

is not already an owner of the company? Although

at first thought you might be tempted to say, “Whyshouldn’t an owner be able to do whatever hewants with his interest?”—think again Consider that

if you happen to be one of the continuing owners

in the company, you might be horrified if a owner were to sell out to an unqualified, unin-formed or just plain ornery new owner, who—even

co-if she purchased a minority share—would havemuch power to make your life miserable And, ofcourse, things would be far worse if an outsider

stood to gain a majority interest in your company,

since this would give her an opportunity to all buttake your company away from you

EXAMPLE: Brothers Frank and Eldon, along

with Eldon’s wife, Ethel, open a boutique

computer store and service business They

create a corporation with each relative owning

a one-third stock interest and each serving as a

board member No buy-sell agreement is

prepared A few years later, after the service

part of the business has become successful, they

receive a favorable buyout offer from a

com-petitor—an owner of a chain of inexpensive

computer stores Frank has no interest in

sell-ing his shares—he wants to keep the business

in the family and eventually have his daughter

Emily succeed him Eldon and Ethel, on the

other hand, have been looking forward to early

retirement and jump at what they see as a

golden opportunity to cash out Since neither

the corporate law in their state nor the

corporation’s bylaws require all owners to

ap-prove a transfer of an owner’s shares in the

corporation, Eldon and Ethel sign a contract to

sell their two-thirds ownership in the company

to the chain operator The new owner quickly

votes her newly acquired, two-thirds

control-ling interest to elect herself and her husband

to fill the two recently vacated board seats

Frank is left with a one-third interest in a

busi-ness that he can no longer run independently

A “Right-of-First-Refusal” provision gives the

company, and usually the continuing

(nontransferring) owners individually, the choice

to buy a co-owner’s interest before an outsider is

allowed to make a purchase (or otherwise receive

an interest in the company) If the continuing

owners decide they do not want to work with a

prospective new owner, the company or the

own-ers individually can exercise their right to buy the

transferring owner’s interest On the other hand, if

the owners approve of the transferee potential

new owner, they can elect not to buy the

co-owner’s interest—essentially approving the sale

(or other transfer)

Here are the details of how our

Right-of-First-Refusal provision works with respect to potential

sales of an interest by an owner to an outsider

(We discuss how our clause covers sales to ers and gifts of interests—the two other most com-mon types of transfers—later in this chapter).When an owner receives an offer from an outsider

insid-to buy his ownership interest, a fusal provision requires that owner (let’s call herthe “transferring owner”) to submit written notice

Right-of-First-Re-to the company of her intent Right-of-First-Re-to sell her interest,along with the terms of the proposed sale Thecompany and the continuing owners then have anoption to buy the interest (at the same price as or adifferent price from that offered by the outsider,depending on which price option is checked in thebuy-sell agreement—also discussed below)

If the company and the continuing ownersdecline to purchase all of the transferring owner’sinterest, the transferring owner is free to sell herinterest to the outsider The transferring ownermust, however, transfer her interest to the out-sider within 60 days, at the same price and termsstated in her notice, or she must start the wholeprocess over again before transferring her interest.For example, if the transferring owner wishes tolower the price to be paid by the outsider for herinterest, or wishes to change other terms of thesale to the outsider to make them more favorable(for example, a lower interest rate on installmentpayments or a longer payment term), she mustsubmit to the company a new notice—essentiallystarting the process over again for the transfer ofthe interest under the new terms

On the other hand, if the company and/or thecontinuing owners decide they do want to pur-chase the entire ownership interest, the outsider isout of luck The company and/or the continuingowners then buy the interest from the transferringowner within a certain period of time

EXAMPLE: Jason, Tim, Chris and Bart are fourequal shareholders and directors of a smalltravel-adventure corporation called Run-a-Muck Jason wants to sell his shares to an out-sider, Kacey According to the Right-of-First-Refusal provision in the corporation’s buy-sellagreement, Jason must first get a signed writ-ten offer from Kacey, then notify the corpora-

tion of his intent to sell his shares to Kacey.

The terms of the proposed sale must be

included in the notice, with a copy of Kacey’s

offer attached Jason’s notice of proposed sale

presented to the corporation is simple, and it

reads as follows:

I, Jason Abercrombie, propose to sell 250

shares in Run-a-Muck to Kacey Gardner

within 60 days of the date of this notice for

$2,500.00 cash ($10.00 per share) Payment

of the purchase price by Kacey Gardner is to

be made in cash on the date of the transfer A

copy of the offer to purchase these shares on

these terms, signed by Kacey Gardner, is

attached to this notice

Run-a-Muck’s Right-of-First-Refusal provisionstates that the corporation and the continuingshareholders have 60 days from receipt of thenotice to purchase all of Jason’s shares If theydon’t elect to purchase the shares, Jason is free

to sell them to Kacey according to the terms ofKacey’s offer Faced with Jason’s notice of aproposed sale, Tim, Chris and Bart promptlymeet as board members and decide that Run-a-Muck, Inc itself will purchase Jason’s shares,shutting Kacey out of the company Run-a-Muck then buys and cancels Jason’s shares

Not every buyer is a bum. We focus here onwhat happens if the continuing ownersdon’t want to allow a sale to an outsider, in whichcase they or the company itself will try to buy out

Section II: Limiting the Transfer of Ownership Interests

Option 1: Right of First Refusal

(a) No owner (“transferring owner”) shall have the right to sell, transfer or dispose of in anyway any or all of his or her ownership interest, for consideration or otherwise, unless he

or she delivers to the company written Notice of Intent to Transfer the interest stating thename and the address of the proposed transferee and the terms and conditions of the

proposed transfer Delivery of this notice shall be deemed an offer by the transferring

owner to sell to the company and the continuing owners the interest proposed to be

of this agreement

If the company and the nontransferring owners do not elect to purchase all of the

interest stated in the notice, the transferring owner may then transfer his or her interest tothe proposed transferee stated in the notice within 60 days after the end of the

nontransferring owners’ purchase option, according to the procedure in Section IV,

Provision 1 of this agreement

Excerpt 1

the transferring owner But in the real world, the

continuing owners may think highly of a person

who wants to buy the transferring owner’s share

And, of course, there can be a real incentive for

the continuing owners to allow a new owner to

buy in, since it means they won’t have to reach

into their own pockets to pay the transferring

owner or ask their company to pony up the cash

The Right-of-First-Refusal clause included in our

buy-sell agreement is shown in Excerpt 1, above

Worksheet If you are interested in having a

Right of First Refusal before an owner can

transfer his interest, check Option 1 on your

worksheet now (Section II, Option 1.)

a Price of the Ownership Interest

What about price? How much should a

transfer-ring owner be paid for her share? Often a

Right-of-First-Refusal provision gives the company and

the nontransferring owners the right to purchase

the transferring owner’s interest at the price the

proposed buyer is willing to pay (assuming the

interest is being sold, not gifted) In other words,

the company and the other owners have to match

this price or allow the sale to take place

One potential problem with this approach is

that a disaffected owner may be tempted to solicit

a phony outside bid, perhaps from a good friend

or relative, to prod her co-owners into buying her

ownership interest at an inflated price To help

cope with this possibility, our

Right-of-First-Refusal provision requires that a written offer for

the purchase of an ownership interest, signed by

the proposed buyer, be attached to the transferring

owner’s Notice of Intent to Transfer Of course,

this is no real guarantee that the offer is genuine,

but at least it makes the purported buyer sign a

commitment to buy the interest—most people will

not want to sign such a statement unless they truly

intend to buy the interest

You can also require a down payment. Someowners may want to go even further andrequire that the proposed buyer tender a signifi-cant down payment to the transferring owner asevidence of good faith, and that the transferringowner present evidence of this payment (check

or money order) with the copy of the signed,written offer presented to the company

You can avoid this problem altogether byhaving your agreement provide that the company

or continuing owners buy an owner’s interest der a Right of First Refusal at the “AgreementPrice”—a price predetermined in the buy-sellagreement itself (we cover the Agreement Price inChapter 6) In this case, even if the transferringowner receives a higher offer from the outsider,she must sell to the company or the continuingowners at the Agreement Price, if they so desire.This alternative has the virtue of protecting thecontinuing owners from being forced into busi-ness with an outsider who is willing to pay aninflated price—one that the continuing ownerscan’t afford or aren’t willing to match Of course,this provision is weighted heavily toward theinterests of the continuing owners and is lessfavorable to a transferring owner, who could end

un-up selling her interest for less than it’s reallyworth

Using the Agreement Price can help avoid estate taxes. In limited circumstances, there

is an additional reason to require the transferringowner to sell at the agreement’s predeterminedbuyout price, rather than requiring the company

or continuing owners to match an outsider’sprice By requiring any and all departing owners

to sell out at the Agreement Price, you take a bigstep towards establishing a reasonable value forthe company for estate tax purposes (Estate taxesare the taxes that may be owed to the governmentupon a person’s death.) See Chapter 9, SectionB4, Rule 3 for more on this

The options in our agreement that cover the

price to be paid under a Right of First Refusal are

shown in Excerpt 2

Worksheet If you checked Option 1, “Right

of First Refusal” in Section II, also:

• check Option 1a if you want your

Right-of-First-Refusal clause to require the company

and the nontransferring owners to match

any amount offered by a buyer, or

• check Option 1b if you want your

Right-of-First-Refusal clause to require the company

and the nontransferring owners to pay only

the buyout price set forth in the agreement

and not be bound to match any amount

offered by a buyer

b Effect on Minority Owners

If you are a minority owner, it’s especially

impor-tant to understand that a Right-of-First-Refusal

provision alone does not guarantee you’ll be able

to sell your interest—either to an outsider or to

your co-owners In fact, this type of provision canhave the effect of preventing a minority ownerfrom selling her interest (except to the company

or the majority owners at a dirt-low price).Here’s why: A Right-of-First-Refusal provision isonly triggered when you get an offer from some-one who wants to buy your interest But for mosttypes of small businesses, there is a very thin—oroften no—market for minority interests In short,

a minority owner may find it virtually impossible

to find a buyer who will make a legitimate offerfor her interest at anything but a flea marketprice And if you can’t get an offer, you can’t trig-ger the Right-of-First-Refusal provision that allowsthe company or the nontransferring owners to buyyour interest To guarantee that you’ll be able tocash out your interest, it’s important to also in-clude a “Right-to-Force-Sale” clause in your buy-sell agreement (discussed in Chapter 3)

The flip side of the coin is that, for minorityowners, a Right-of-First-Refusal provision may noteven fulfill its main purpose—to give all ownersthe ability to control the ownership of theircompany That’s because all Right-of-First-Refusal

(c) Price and terms

Option 1a: Price and terms in offer

If the proposed transfer is a sale of the owner’s interest, the company and thenontransferring owners shall have the right to purchase the interest of the transferringowner only at the purchase price and payment terms stated in the Notice of Intent toTransfer submitted to the company by the transferring owner The price and terms inthis notice override the general Agreement Price selected in Section VI of thisagreement and the agreement terms selected in Section VII

If the proposed transfer is a gift of the owner’s interest, the company and thenontransferring owners shall have the right to purchase the interest of the transferringowner at the Agreement Price selected in Section VI and according to the manner ofpayments and other terms of the purchase as established in Section VII of this agreement

Option 1b: Price and terms in agreement

The company and the nontransferring owners shall have the right to purchase theinterest of the transferring owner at the Agreement Price selected in Section VI andaccording to the manner of payments and other terms of the purchase as established inSection VII of this agreement

Excerpt 2

provisions rely on purchasing power to regulate

transfers of interest Because of lack of company

or personal funds, minority owners armed only

with a Right-of-First-Refusal provision may not be

able to prevent a majority owner from selling to a

proposed buyer If the company itself or the

mi-nority owners don’t stand a chance of being able

to pony up a healthy sum to buy out the majority

owner, their Right of First Refusal doesn’t mean

much They could be stuck with a new

control-ling owner who is a tyrant, a competitor or simply

an inactive owner who will reap the benefits of

their work

Check with your attorney This is a good

example of why minority owners should

check with a small business attorney to

investi-gate the pros and cons of any

Right-of-First-Re-fusal provision before signing a buy-sell

agree-ment Again, most of our advice is tailored to

small businesses where the owners own largely

equal shares of the company, and where all

ac-tively participate in the company’s day-to-day

op-erations If you are a minority owner, be sure to

have an attorney look over your agreement We

cover finding expert help in Chapter 10

c Who Can Buy the Interest?

Our Right-of-First-Refusal clause provides that

ei-ther the company or the continuing owners can

buy an owner’s interest to stop the transfer of an

owner’s interest

In the case of a corporation, if the corporate

entity, rather than the continuing owners, buys an

owner’s shares, it “cancels” them, which means

the remaining owners’ percentage of ownership

in the company increases accordingly Similarly,

in the case of partnerships and LLCs, if the

com-pany buys the departing owner’s interest, that

in-terest is “liquidated,” and the continuing partners’

members’ ownership percentages increase

Compare this to the situation where the

re-maining shareholders, partners or LLC members

decide to individually buy the transferring

owner’s interest When this happens, the ring owner’s shares or interest is not canceled orliquidated, but is reallocated among the remainingowners

transfer-EXAMPLE: Kate, Nancy and Lisa own andoperate a small, member-managed LLC asequal one-third owners Kate decides shewants to leave the LLC and finds a willingbuyer who signs a written offer to buy her LLCinterest for cash If the LLC under the Right ofFirst Refusal in its buy-sell provisions, buysback Kate’s interest, Nancy and Lisa becomeequal one-half owners of the business after thepurchase The same percentage result occurs ifNancy and Lisa both decide to individually buyback one-half of Kate’s interest

In Chapter 4, we discuss the procedure andissues (mainly tax advantages and disadvantages)relating to who the buyer will be—the company

or the continuing owners For now, just stand that it’s best to use a procedure that allowsfor both approaches (ours does), leaving the de-termination as to who should be the buyer to bemade at the time of a buyout

under-2 What If an Owner Wants to Sell His Interest to a Current Owner?

As mentioned above, when an owner tries to sellhis small business interest, he may not have muchluck finding an outsider who’s willing to make anoffer A situation where a co-owner buys anowner’s interest—let’s call that an interownertransfer—is more likely

Many companies allow co-owners to transfertheir interests among themselves freely—withoutbeing subject to a Right-of-First-Refusal or otherbuy-sell provision After all, a transfer to a currentowner would not bring a stranger into the owner-ship ranks—the current owners already sharemanagement duties with each other But insituations where there are more than two owners,there’s another reason to establish rules governing

interowner transfers: Without rules, there is no

mechanism to prevent one or two co-owners

from grabbing control of the business by

snap-ping up a transferring owner’s share Here’s how

this can happen:

EXAMPLE: Serena, Petra and Alex start a small

corporation that sells mailing lists, with each

owning 333 shares of the 999 shares that were

initially released They do not create a buy-sell

agreement After suffering through several

management quarrels with Petra, and deciding

that the work is not personally meaningful to

him, Alex decides he wants to cash out his

interest and go to cooking school Needing a

large chunk of change for tuition, he secretly

negotiates a deal with Serena, who agrees to

buy his shares without telling Petra, for whom

Alex and Serena have developed a general

distaste The result is that Serena is able to

purchase all of Alex’s interest without Petra

knowing, and ends up with a total of 666

shares and control of the company Poor Petra

no longer has a say in managing the company

To avoid situations where an equal owner

suddenly and surprisingly becomes a majority

owner, you can have your Right-of-First-Refusal

clause apply to sales to current owners as well as

outsiders In other words, whenever an owner’s

interest is offered for sale to a current owner, you

can give all co-owners the right to buy it The

language that covers this choice in the agreement

is shown in Excerpt 3

Worksheet If you checked Option 1, “Right

of First Refusal,” in Section II, also:

• check Option 1c if you want your Right ofFirst refusal to apply to sales to outsidersand current owners alike, or

• check Option 1d if you want your First-Refusal clause to apply only to sales tooutsiders

Right-of-3 What If an Owner Wants to Give Away Her Interest (or Put It in a Trust)?

There are two common approaches a buy-sellagreement can take with regard to gifts of owner-ship interests and transfers to trusts: One, youragreement can make gifts of ownership interestsand/or transfers to trusts subject to the sameRight-of-First-Refusal provision that sales aresubject to Two, your agreement can exempt giftsand/or transfers to trusts from the Right-of-First-Refusal procedure, essentially giving owners freerein to give away their ownership interests

(d) Potential transferees

Option 1c: Right of First Refusal applies to sales to current owners

The Right-of-First-Refusal clause in this agreement shall apply to all potentialtransferees, whether they are current owners of any interests in the company or not

Option 1d: Right of First Refusal does not apply to sales to current owners

The Right-of-First-Refusal clause in this agreement shall only apply to those potentialtransferees who are not current owners of any interests in the company

Excerpt 3

a Estate Planning and Living Trusts

Let’s first take a brief look at estate planning in

the context of why allowing owners the flexibility

to give away their ownership interests freely, or

to put them into trusts, may be important to you

and your co-owners

One aspect of estate planning is avoiding

probate Probate is a costly and time-consuming

court process during which a deceased person’s

will is proved authentic, all property subject to

the will is inventoried and appraised and relatives

and creditors are notified Finally, the property is

distributed to the people entitled to inherit it

Probate can take months or even years and can

cost as much as 5% of the value of the probated

property If the family members or business

partners of a deceased owner have to wait one or

more years to gain title to their ownership

interests from a probate court, business can grind

to a halt For this reason, keeping ownership

interests—and the controlling voting power and

management of the company—out of probate is

essential to ensure the smooth transition of the

business Giving away part or all of your

owner-ship interest or putting it into a probate-avoidance

living trust before you die (see below) can avoid

the hassles of probate

Another equally important aspect of estate

planning is reducing or eliminating federal estate

taxes The federal estate tax is a form of

inherit-ance, or death, tax that is taken from your estate

after you die Whatever property you leave behind,

including an ownership interest in a small business,

may be subject to federal estate taxes when you

die—although the federal government currently

exempts the first $1 million from the tax (and, if

you’re very lucky, your business may qualify for

the federal family business estate tax deduction—

discussed in Chapter 9, Section B2) To

oversim-plify greatly, giving away part of your ownership

interest to family members in $11,000 chunks

each year is one excellent method of avoiding

es-tate taxes We discuss eses-tate taxes more fully,

in-cluding whose estate may incur them and several

common methods of eliminating or loweringthem, in Chapter 9, Section B

Putting an ownership interest into a living trustcan be an integral part of avoiding probate and,sometimes, estate taxes Here’s how probate-avoidance living trusts work: When a businessowner is at an age where estate planning becomespractical, he signs his ownership interest over to alegal entity called a trust The business owner isthe trustee of the trust and has control over theownership interest, just as if he owned it in hisown name Upon his death, the ownership interest

is transferred to the beneficiaries of the trust—usually the owner’s spouse and/or children—without having to go through probate

Also, certain tax-avoidance trusts, such as “AB”trusts, are a routine way for couples to plan toreduce estate taxes (Tax-avoidance living trustsare discussed further in Chapter 9, Section B2.)Because putting ownership interests in livingtrusts usually doesn’t threaten the company or thecontinuing owners with an actual change ofownership—it’s really just a paper transfer—manycompanies exempt from the Right of First Refusal

an owner’s transfer of his interest to a trust, aslong as the following conditions are met:

• the power to revoke the trust remains withthe grantor (the owner of the interest), and

• the grantor (the owner of the interest) is atrustee of the trust

If the owner ceases to be a trustee of the trust(for example, a new trustee takes over becausethe owner becomes mentally incompetent), thenew trustee would control the owner’s interestand be able to vote on the management of thecompany Therefore, this change should be con-sidered an ownership transfer that causes theRight-of-First-Refusal clause to kick in, giving thecompany and the other owners the right to buythe interest back

Our Right-of-First-Refusal covers transfers totrusts in subsection (e) of Option 1 It is shown inExcerpt 4

Worksheet If you want transfers to trusts to

be exempt from the Right of First Refusal,

you do not have to do anything If you want

trans-fers to trusts to be subject to the Right-of-First

Re-fusal, you can simply remove subsection (e) from

your word processing file (Section II, Option 1.)

If so, make a note to do this on your worksheet

b Restricting Gifts of Ownership Interests

The provision allowing transfers to living trusts

above does not address the matter of gifts—giving

ownership interests to relatives or long-term

employees, usually for estate planning purposes

Our Right-of-First-Refusal clause works with

respect to proposed gifts in almost the same way

as it does for proposed sales Before giving part

or all of her interest away, the owner who is

considering giving a gift of her interest (the

“transferring owner”) must give notice to the

company of the proposed transfer, including the

proposed recipient’s name and address However,

the provision says that in this case the price and

terms at which the company or the nontransferring

owners can purchase the interest are the standard

Agreement Price and terms established in other

sections of the buy-sell agreement (we cover the

Agreement Price in Chapter 6) If the company

and the other owners decline to purchase the

ownership interest, the transferring owner is free

to give away her interest But if the company or

other owners decide they don’t want the transfer

to go through, they must pay the owner for the

interest according to the price and terms in theagreement Keep in mind that, if the company orthe nontransferring owners buy the interest, thetransferring owner will have cash available from hersale proceeds that she is free to give away to rela-tives for estate planning purposes

Our Right-of-First-Refusal clause does not empt gifts because most owners do not want theirco-owners to be able to transfer their interest tooutsiders without any kind of oversight or approvalprocess—even if the outsiders in this case are chil-dren or other relatives The reasons for this are thesame as for restricting any transfer—mainly so thatyou don’t have to work with and share control ofthe company with a new, untested owner (seeChapter 1, Section B for other reasons) Supplyingthe company and the continuing owners with thediscretion to allow or disallow such gifts allowsthose whose livelihood could be affected byownership changes to make that decision How-ever, you and your co-owners may have a differentperspective, and wish to allow unrestricted gifts ofownership interests In that case, see subsection c,below, for an alternative

ex-(e) This Right-of-First-Refusal provision shall not apply to an owner’s transfer of an ownershipinterest to a trust as long as the following conditions are met:

i) the power to revoke the trust remains with the grantor (the owner of the interest), andii) the grantor (the owner of the interest) is a trustee of the trust

If either of the above conditions ceases to be true, this change will subject the

ownership interest to this Right-of-First-Refusal

Excerpt 4

Many older business owners want the

ability to plan their estates to best avoid

pro-bate and estate taxes, and so should beware of how

a buy-sell agreement can hinder an owner’s

indi-vidual estate plan If you are of an age where

es-tate planning is high up on your to-do list, you

should have your estate planner look over your

buy-sell agreement before you sign it, to make

sure it won’t conflict with your estate-planning

goals

Worksheet If you want gifts of ownership

interests to be subject to the Right of First

Refusal discussed above, you don’t need to check

anything on your worksheet or change anything

in the buy-sell agreement

c Allowing Unrestricted Gifts of

Ownership Interests

You and your co-owners may not be comfortable

parting with the right to give away your interests

to whomever you please If you and your company

choose not to place restrictions on the transfer of

owners’ interests to their family members, you

can simply check a box in your agreement so that

the Right-of-First-Refusal provision does not apply

to gift-giving Of course, remember that in

allow-ing the unchecked giftallow-ing of ownership interests,

owners give up some of their collective control

over the ownership of the company The option

from our agreement is shown in Excerpt 5

Worksheet If you are interested in allowing

owners to give away their ownership

inter-ests to their relatives freely, not subject to a Right

of First Refusal, check this option on yourworksheet now (Section II, Option 2.)

Voluntary transfers only. Our Refusal provision applies only to a volun-tary, lifetime transfer of an interest by an owner

Right-of-First-by sale, gift or otherwise, not to a court-orderedtransfer to an ex-spouse as part of a divorce, to atransfer to an owner’s estate or beneficiaries upon

death or to other involuntary transfers Other

buy-sell provisions in our agreement, discussed inChapter 3, cover these additional types of trans-fers

C Absolute Transfer Restrictions

Just saying “no” to the possibility of all ownershiptransfers, including gifts and sales to outsiders andcurrent owners, is another way that owners cankeep control of company ownership But wedon’t recommend this all-or-nothing approach.Not only is it inflexible, but it also doesn’t reason-ably balance the needs of an individual ownerwith those of the continuing owners

A complete ban on the transfer of ownershipinterests would prevent any owner from selling,gifting or otherwise transferring her interest (un-less, of course, her co-owners agree to change orignore the ban later)

A similar clause that has the same effect—called “No Transfers Without Consent”—wouldrequire an owner to get the approval of her co-owners before selling to an outsider or makingother transfers No question, either of these provi-sions gives a huge amount of power to the other

Excerpt 5

Option 2: Transfers to Relatives Can Be Made Without Restriction or Approval

Notwith-standing Any Other Provision in This Agreement

owners; they really can “just say no” to the owner

who wants to sell, without even having to buy his

interest (At least with the Right-of-First-Refusal

clause, discussed above, the continuing owners

have to fork out some cash to stop a transfer,

meaning it’s less likely they’ll disallow a sale on a

whim.) One nasty result of a

No-Transfers-With-out-Consent clause may be that the majority

own-ers withhold their consent to a sale and then

pres-sure a minority owner to sell his ownership

inter-est to the company or to them at an unfairly low

price

Here’s an example of what such a clause

would look like

No Transfers Without Consent

No owner shall sell, transfer or in any

way dispose of any of his or her ownership

interest or any right or interest in the

company without obtaining prior written

consent of the company and of all other

owners

A restriction that provides a little more flexibility

is a clause that provides for “Transfers to Qualified

Buyers Only.” Here, transfers to qualified buyers

are allowed, and you and your co-owners have

the opportunity to define the term “qualified

buyer” in advance in your buy-sell agreement For

example, your agreement could require a potential

buyer to hold a license for a particular profession

or have a certain number of years of experience

in your particular field But keep in mind that

while this restriction protects the nontransferringowners from having to share management with anobviously unqualified person, most business own-ers feel that it doesn’t offer them adequate protec-tion since it doesn’t give them a way to stop asale to a qualified new owner for other reasons.Here’s an example of what such a clausewould look like

Transfers to Qualified Buyers Only

No owner shall sell, transfer or in anyway dispose of any of his or herownership interest or any right or interest

in the company except to a buyer or otherproposed transferee who has [insert qualifications, such as “five years’, full- time experience in selling real estate”]

The opposite of this restriction is a fers-to-Certain-Persons” clause Typical uses of thistype of provision would be to prohibit a sale to acompetitor, to any existing owner who would thenown a share greater than 50% or to any buyerwhose purchase would jeopardize a key taxelection or violate state law For example, if yourcompany is an S corporation, you may prohibit asale to a non-US citizen, a corporation or a partner-ship, all of whose ownership would terminate Scorporation tax treatment This type of restriction isnormally legal as long as you do not prohibit trans-fers to outsiders based on discriminatory criteriasuch as a buyer’s race or sex

“No-Trans-Here’s an example of what such a clause

would look like

No Transfers to Certain Persons

No owner shall sell, transfer or in any

way dispose of any of his or her

ownership interest or any right or

interest in the company to a buyer or

other proposed transferee who is [insert

restricted class, such as “an existing

owner who would, after such transfer,

own 50% or more of the company”]

These transfer restrictions are not included in our buy-sell agreement Since weremain unconvinced that these clauses provideflexible and intelligent solutions for controllingthe ownership of small companies, we do notinclude them in our agreement (A Right-of-First-Refusal clause does a good job of restrictingownership in most cases.) In addition, in at leastsome states, courts have refused to enforce suchstrict prohibitions on the sale of ownership inter-ests If you are nevertheless interested in usingone of the clauses, get the advice of a small busi-ness lawyer or other expert before you do so Wecover finding expert help in Chapter 10 ■

Providing the Right to Force Buyouts

3

A Why Provide the Right to Force the Sale of an Ownership Interest? 3/3

1 Restoring Control Over the Company’s Ownership 3/3

2 Types of Forced Buyouts 3/4

B What If an Owner Wants to Retire or Stop Working? 3/5

1 Option of Company and Continuing Owners to

Purchase a Retiring Owner’s Interest 3/5

2 Right of Departing Owner to Force a Sale 3/7

C What If an Owner Becomes Mentally or Physically Disabled? 3/13

1 Option of Company and Continuing Owners to

Purchase a Disabled Owner’s Interest 3/13

2 Right of Disabled Owner to Force a Sale 3/16

D What If an Owner Dies? 3/18

1 Business Succession 3/18

2 Deciding What to Put in Your Buy-Sell Agreement 3/19

3 Option of Company and Surviving Owners to

Purchase a Deceased Owner’s Interest 3/22

4 Right of Estate, Trust or Inheritors to Force a Sale 3/24

E What If an Owner Divorces? 3/26

F What If an Owner Loses His or Her Professional License? 3/29

G What If an Owner Files for Personal Bankruptcy? 3/31

H What If an Owner Defaults on a Personal Loan? 3/33

1 Encumbrances Allowed 3/33

2 Encumbrances Not Allowed 3/35

I What If an Owner Is Expelled? 3/35